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This is a guest post from Christopher Pavese, CFA, Chief
Investment Officer at Broyhill Asset
Management. He and his team have recently been on a
research-intensive trip in China, and he
has kindly agreed to share what he found. Visit his blog
(The View from the
Blue Ridge) for more analyses.

The Union of Soviet Socialist Republics (USSR) was a single-party
state ruled by the Communist Party. The state was structured
under a highly-centralized government and a command economy, meaning
both capital and resources could be mobilized quickly and
proficiently. However, speed and agility do not guarantee
economic efficiency and can often result in a massive
misallocation of capital, which ultimately comes at a high price.
This is a lesson China has
chosen to ignore as signs of capital misallocation are widespread
throughout the People’s Republic today.

The
Economist Intelligence Unit (EIU) estimates that average
living space per head is over 30 square meters in China,
extraordinarily high given the country’s current income levels.
“Based on international comparisons, a country at China’s level
of GDP per head should have 20 square meters of living area,
which would mean that China is 53 percent over-housed," according
to the EIU. Despite China already being the most “over-housed”
country in the world, official data show a further three billion
square meters of residential property
currently under construction, according to
The Wall Street Journal.

China’s real estate
sector directly accounts for roughly 12 percent of GDP. To help
put this figure in perspective, consider that private real estate
investment in the US reached a staggering 6.3 percent of GDP at
the peak of the housing market, in 2005. But China’s astonishing
figure also ignores countless related industries driven by the
bubble in construction (i.e. steel, cement, etc.) and the
illusion of wealth created by a historic credit binge (i.e.
appliances, home furnishings, etc.). A more inclusive estimate of
Chinese real estate’s impact on GDP could be twice the commonly
reported figures. Our friend, Vikram Mansharamani, provided some
color into the excesses in the steel sector in his excellent
book,
Boombustology:

"When thinking about over investment and the potential for a
bust, the steel industry exemplifies overcapacity. Chinese steel
production has grown from 23 million tons in 1977 to a run rate
of approximately 650 million tons during the first half of 2010.
This growth has taken the Chinese steel industry’s share of
global steel production from around 3 percent in 1977 to almost
50 percent by 2010.

"If we take a moment to break down the sources of demand for
Chinese steel, one finds a potentially reflexive relationship
with the property
market. Anecdotal evidence suggests that up to 20 percent of
Chinese steel production is being used to construct more steel
mills!

"Most believe that utilization has been running between 65
percent and 75 percent. The WSJ reported in 2009 that there existed 200
million tons of excess capacity, while UBS analysis conducted in early 2010 suggested
there was about 175 million tons of excess capacity. To put these
numbers in context, 175 million tons of annual steel production
is more than the production of South Korea and Japan – combined!
Steel does not appear to be an outlier; similar grandiose
statistics can be found for the size of the Chinese cement
(greater than the rest of the world combined) and aluminum
industries.”

With home prices now following transaction activity sharply
lower, the biggest risk for the Chinese economy, as well
as the rest of the world, is a sharp slowdown in new
construction. Granted, official data still paint a more
“balanced” picture, consistent with the standard responses we
received from various developers throughout the country. When
asked about the outlook for real estate prices we were regularly
told that, “prices have reached bottom,” or that “prices have
stabilized,” but curiously, when asked how much they had fallen,
the immediate response was always, “they have not fallen.” Odd.
Perhaps the laws of economics work differently in a command
economy, but in a market economy prices tend to fall before
“reaching bottom.”

While interested parties remain in denial, disagreements between
friends are often settled using the following equation: “Figures
don’t lie, but liars figure.” Consider that China Vanke, the
nation’s top property developer, suffered a 40 percent drop in
January sales. Consider that sales of excavators and bulldozers
dropped by 53 percent and 67 percent respectively in January,
according to China Construction Machinery Business Online. And
consider that inventory levels recently reached historic highs at
the same time sales activity has dropped off a cliff.

Figures don’t lie and liars figure, but a picture is worth a
thousand word. So we’ll summarize how we view the Chinese
economy’s attempt at rebalancing away from domestic investment
and toward consumption with a few pictures. But first, consider
that one of the most insightful nuggets from our visits with
various local government officials was the common belief that,
“Developing new cities and building new infrastructure will
increase consumption.” Judging by the foot traffic shown in this
Zhuhai Home Furnishings Mall, you could say that I am slightly
suspicious. Please note that this particular savvy shopper is
none other than our own, Hunt Broyhill, not a Chinese home owner.

And the striking gentleman at the railing in the photo on the
right is none other than Cullen Thompson, CIO of Bienville Capital
Management. Also, not a Chinese home owner, although full
disclosure, the two women shown on the left picture, may very
well be actual Chinese consumers.

We did not have any more success finding foot traffic at The
Global Furnishing Design and Exhibition Center in Shanghai, the
largest city in the world, and one where you might expect to see
more than a few signs of increased consumption.

Not so much.

Victor Shih, author of
Factions and Finance in China, estimates that the top one
percent of Chinese households own up to half of the bank deposits
in the country. You might have expected to see at least a handful
of the ten million plus people this represents shopping on a
weekday afternoon.